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ONGOING ANALYSIS PROJECT An important part of learning is application. To learn accounting, we must practice the skills taught and apply those skills to real world problems. To that end, we have designed a project to reinforce the lessons in each module and apply them to real companies. The goal of this project is to complete a comprehensive analysis of two (or more) companies in the same industry. We will then create a set of forecasted fi companies' equity. This is essentially what financial analysts and many creditors do. We might not aspire to be an analyst or creditor, but by completing a project of this magnitude, we will have mastered financial reporting at a sufficient level to be able to step into any role in an organization. The goal of Module is assignment is to obtain and begin to explore the financial reports for two publicly traded companies that compete with each other. 1. Select two publicly traded companies that compete with each other. They must be publicly traded, as private company financial statements will not be publicly available. While the two companies do not need to be head- to-head competitors, their main lines of business should broadly overlap. 2. Download the annual reports for each company, and peruse them. At this stage, choose companies that are profit able (net income is positive) and that have positive retained eamings and stockholders' equity. Select companies whose financial statements are not overly complicated. (Probably avoid the automotive, banking, insurance, and financial services industries Automotive companies have large financial services subsidiaries that act like banks for customers, which complicates the analysis. Banking, insurance, and financial services have operations that differ drastically from the usual industrial companies common in practice. While these companies can be analyzed, they present challenges for the beginning analyst.) 3. Use the SEC EDGAR Website to locate the recent Form 10-K (or other annual report such as 20-F or 40-F) (www.sec.gov). Download a spreadsheet version of financial statements. Use Appendix 1A as a guide. 4. Use the annual report and the financial statements, along with any websites, to assess the companies' business environment. Use Porter's Five Forces or a SWOT analysis to briefly analyze the competitive landscape for the two companies. The aim is to understand the competitive position of each company so we can assess their financial statements in a broader business context 5. Explore the financial statements, and familiarize yourself with the company basics. The following give an indi- cation of some questions that guide us as we look for answers. What accounting standards are used, U.S. GAAP, IFRS, or other? What is the date of the most recent fiscal year-end? Determine the relative proportion of short and long-term assets. Determine the relative proportion of liabilities and equity. ONGOING ANALYSIS PROJECT This ongoing project began in Module 1 and continues through most of the book, even if previous segments were not completed, the requirements are still applicable to any business analysis. The goal of this module's project is to perform vertical analysis of the balance sheet and income statement, assess cash flows, and determine market capitalization. 1. BalanceSheet Analysis. Prepare a common-size balance sheet. To facilitate this, obtain the balance sheet in spreadsheet form from the SEC website at the the "Interactive Data" link on the search results page. Look for major differences over time. Some questions to consider: What are the company's largest assets? Largest liabilities? What proportion of total assets is financed by owners? (Hint: Compare with total equity.) What proportion of total assets is financed by nonowners? 2.Income Statement Analysis. Prepare a common size income statement. Express each item on the income state- ment as a percent of total sales or revenue. Do this for all years on the income statement. Look for major differences over time and between the companies. Do any patterns emerge? Some questions to consider: What are the major expenses? Are there any unusual or discontinued items? Are they large in magnitude? Was the company more or less profitable when compared with the prior year? 3.StatementofCash Flows Analysis. Determine the size and direction (cash source or use) of cash flows from operations, investing, and financing. One goal is to understand the company's pattern of cash flows and to form an opinion about the general strength of its cash flows. Some questions to consider: What were the cash flows from operations? Were they positive? Were operating cash flows smaller or larger than net income? Did the company generate or use cash from investing activities? Did the company generate or use cash from financing activities? 4. Market Capitalization. Determine the market capitalization at the most recent year-end. Determine the number of shares outstanding from the balance sheet. Recall that shares outstanding is total shares issued less any treasury shares. Obtain the year-end stock price from an investment website such as Seeking Alpha or Yahoo Finance. Com- pare market cap with the book value (total equity) of the company. ONGOING ANALYSIS PROJECT This ongoing project began in Module I and continues through most of the book, even if previous segments were not completed the requirements are still applicable to any business analysis Analysis of financial statements commonly includes ROE disaggregation and scrutiny of its components as ex- plained in this module. 1. Compute ROE for all three years reported on the income statement. (Hint: Do your companies report noncon trolling interest on the income statement and balance sheet? If so, make certain to use income available to the controlling interest (NICI) in the numerator and equity of the controlling interest (CI) in the denominator. To compute ROE for three years, we must determine average stockholders' equity for three years, which means we need four balance sheet amounts. Because the balance sheets of each company will report only two years, we must collect prior years' financial statements.) 2. Compute RNOA and its two components (NOPM and NOAT) for all three years reported on the income state- ment. We must use balance sheet numbers for four years to obtain three averages of net operating assets. Exam- ine the income statements and balance sheets to determine the operating and nonoperating items. (Hint: Use an online source to understand any line items not described in the textbook. Use cell references in the spreadsheet to compute NOPAT and NOA and the various ratios.) 3. Compare ROE and RNOA and identify differences over time and between the companies. Evaluate the compa- nies' returns and answer questions such as the following: Which company is more profitable? How do the operating and nonoperating portions of ROE compare? Compare the ROE and RNOA with the graph on page 3-25. If the ratios for the companies under analysis differ from the graph, is there an explanation? Is the net operating profit margin similar for the two companies? Given that they are roughly in the same industry, major differences should prompt further exploration Are the companies net operating asset turnover ratios similar or markedly different? Calculate and compare the cash conversion cycle for each year. 4. Determine FLEV and Spread and the noncontrolling interest ratio (if applicable). Show that: ROE = [RNOA + (FLEV X Spread)] x Noncontrolling interest ratio Compare the components of the equation for each company over time and follow up on any differences 5. Compute the four ratios from Appendix 3B for the recent three years for each company: current ratio, quick ratio, liabilities-to-equity, and times interest earned. Compare the ratios for the companies under analysis and identify differences over time and between companies. Evaluate each company's ability to pay its debts in the short term (liquidity) and the long term (solvency), and in the process address the following: Which company is more liquid? More solvent? Look at the bar chart in Exhibit 3B. 1. If the ratios differ from the industry norm, is there an explanation(s)? . Do the ratios change over time? If yes, does the change make sense given the economic and competitive factors that affect the industry and the companies? ONGOING ANALYSIS PROJECT This ongoing project began in Module I and continues through most of the book, even if previous segments were not completed, the requirements are still applicable to any business analysis. In this module, we focus on the companies'nonoperating activities, namely, we will assess liquidity and solvency and form an opinion about the companies' overall credit risk. 1. Examine the companies balance sheets and statements of cash flow. What is the demand for credit at each company? Did the company obtain new debt or repay old debt? Look at the investing section to determine what the companies did with any additional debt they raised. This will provide a big picture of the financing activities for the year. 2. Consider the source of debt-who supplies the credit? Read the debt footnote and the lease footnote if the company uses leases). Does it use short or long-term debt? Is the debt from banks or is it publicly traded? Does the debt carry covenants that provide protection to creditors? Pay special attention to any mention of default or renegotiated covenants as this can indicate a decrease in creditworthiness. 3. Extend the analysis by computing the following ratios for the current and prior years for the companyies). (Assume a marginal tax rate of 37%.) . Return on equity (ROE) Return on assets (ROA) Return on net operating assets (RNOA) Times interest eamed Operating cash flow to debt Free cash flow to debt Current ratio Quick ratio Liabilities-to-equity ratio Total debt-to-equity ratio Module 4 Credit Risk Analysis and Interpretation 4-52 4. Compare the ratios over time for the company. Is the company more or less liquid or solvent than last year? Compare companies to determine which company is more liquid and solvent . Find two or more credit ratings for the company and use the descriptions in Appendix 4A to interpret the ratings. Read any analysts' credit reports available and compare them to our analysis Compute and interpret the Altman Z-score for the companies and use Exhibit 4.8 to interpret the scores. Is the company at risk for bankruptcy? Does this assessment make sense in the context of other analyses in cluding analysis from prior modules)? . Conclude with an assessment about the company's liquidity and solvency. We should express an opinion about whether the company has an appropriate level and types of debt and whether we expect the company to continue operating with its existing capital structure. ONGOING ANALYSIS PROJECT An important part of learning is application. To learn accounting, we must practice the skills taught and apply those skills to real world problems. To that end, we have designed a project to reinforce the lessons in each module and apply them to real companies. The goal of this project is to complete a comprehensive analysis of two (or more) companies in the same industry. We will then create a set of forecasted fi companies' equity. This is essentially what financial analysts and many creditors do. We might not aspire to be an analyst or creditor, but by completing a project of this magnitude, we will have mastered financial reporting at a sufficient level to be able to step into any role in an organization. The goal of Module is assignment is to obtain and begin to explore the financial reports for two publicly traded companies that compete with each other. 1. Select two publicly traded companies that compete with each other. They must be publicly traded, as private company financial statements will not be publicly available. While the two companies do not need to be head- to-head competitors, their main lines of business should broadly overlap. 2. Download the annual reports for each company, and peruse them. At this stage, choose companies that are profit able (net income is positive) and that have positive retained eamings and stockholders' equity. Select companies whose financial statements are not overly complicated. (Probably avoid the automotive, banking, insurance, and financial services industries Automotive companies have large financial services subsidiaries that act like banks for customers, which complicates the analysis. Banking, insurance, and financial services have operations that differ drastically from the usual industrial companies common in practice. While these companies can be analyzed, they present challenges for the beginning analyst.) 3. Use the SEC EDGAR Website to locate the recent Form 10-K (or other annual report such as 20-F or 40-F) (www.sec.gov). Download a spreadsheet version of financial statements. Use Appendix 1A as a guide. 4. Use the annual report and the financial statements, along with any websites, to assess the companies' business environment. Use Porter's Five Forces or a SWOT analysis to briefly analyze the competitive landscape for the two companies. The aim is to understand the competitive position of each company so we can assess their financial statements in a broader business context 5. Explore the financial statements, and familiarize yourself with the company basics. The following give an indi- cation of some questions that guide us as we look for answers. What accounting standards are used, U.S. GAAP, IFRS, or other? What is the date of the most recent fiscal year-end? Determine the relative proportion of short and long-term assets. Determine the relative proportion of liabilities and equity. ONGOING ANALYSIS PROJECT This ongoing project began in Module 1 and continues through most of the book, even if previous segments were not completed, the requirements are still applicable to any business analysis. The goal of this module's project is to perform vertical analysis of the balance sheet and income statement, assess cash flows, and determine market capitalization. 1. BalanceSheet Analysis. Prepare a common-size balance sheet. To facilitate this, obtain the balance sheet in spreadsheet form from the SEC website at the the "Interactive Data" link on the search results page. Look for major differences over time. Some questions to consider: What are the company's largest assets? Largest liabilities? What proportion of total assets is financed by owners? (Hint: Compare with total equity.) What proportion of total assets is financed by nonowners? 2.Income Statement Analysis. Prepare a common size income statement. Express each item on the income state- ment as a percent of total sales or revenue. Do this for all years on the income statement. Look for major differences over time and between the companies. Do any patterns emerge? Some questions to consider: What are the major expenses? Are there any unusual or discontinued items? Are they large in magnitude? Was the company more or less profitable when compared with the prior year? 3.StatementofCash Flows Analysis. Determine the size and direction (cash source or use) of cash flows from operations, investing, and financing. One goal is to understand the company's pattern of cash flows and to form an opinion about the general strength of its cash flows. Some questions to consider: What were the cash flows from operations? Were they positive? Were operating cash flows smaller or larger than net income? Did the company generate or use cash from investing activities? Did the company generate or use cash from financing activities? 4. Market Capitalization. Determine the market capitalization at the most recent year-end. Determine the number of shares outstanding from the balance sheet. Recall that shares outstanding is total shares issued less any treasury shares. Obtain the year-end stock price from an investment website such as Seeking Alpha or Yahoo Finance. Com- pare market cap with the book value (total equity) of the company. ONGOING ANALYSIS PROJECT This ongoing project began in Module I and continues through most of the book, even if previous segments were not completed the requirements are still applicable to any business analysis Analysis of financial statements commonly includes ROE disaggregation and scrutiny of its components as ex- plained in this module. 1. Compute ROE for all three years reported on the income statement. (Hint: Do your companies report noncon trolling interest on the income statement and balance sheet? If so, make certain to use income available to the controlling interest (NICI) in the numerator and equity of the controlling interest (CI) in the denominator. To compute ROE for three years, we must determine average stockholders' equity for three years, which means we need four balance sheet amounts. Because the balance sheets of each company will report only two years, we must collect prior years' financial statements.) 2. Compute RNOA and its two components (NOPM and NOAT) for all three years reported on the income state- ment. We must use balance sheet numbers for four years to obtain three averages of net operating assets. Exam- ine the income statements and balance sheets to determine the operating and nonoperating items. (Hint: Use an online source to understand any line items not described in the textbook. Use cell references in the spreadsheet to compute NOPAT and NOA and the various ratios.) 3. Compare ROE and RNOA and identify differences over time and between the companies. Evaluate the compa- nies' returns and answer questions such as the following: Which company is more profitable? How do the operating and nonoperating portions of ROE compare? Compare the ROE and RNOA with the graph on page 3-25. If the ratios for the companies under analysis differ from the graph, is there an explanation? Is the net operating profit margin similar for the two companies? Given that they are roughly in the same industry, major differences should prompt further exploration Are the companies net operating asset turnover ratios similar or markedly different? Calculate and compare the cash conversion cycle for each year. 4. Determine FLEV and Spread and the noncontrolling interest ratio (if applicable). Show that: ROE = [RNOA + (FLEV X Spread)] x Noncontrolling interest ratio Compare the components of the equation for each company over time and follow up on any differences 5. Compute the four ratios from Appendix 3B for the recent three years for each company: current ratio, quick ratio, liabilities-to-equity, and times interest earned. Compare the ratios for the companies under analysis and identify differences over time and between companies. Evaluate each company's ability to pay its debts in the short term (liquidity) and the long term (solvency), and in the process address the following: Which company is more liquid? More solvent? Look at the bar chart in Exhibit 3B. 1. If the ratios differ from the industry norm, is there an explanation(s)? . Do the ratios change over time? If yes, does the change make sense given the economic and competitive factors that affect the industry and the companies? ONGOING ANALYSIS PROJECT This ongoing project began in Module I and continues through most of the book, even if previous segments were not completed, the requirements are still applicable to any business analysis. In this module, we focus on the companies'nonoperating activities, namely, we will assess liquidity and solvency and form an opinion about the companies' overall credit risk. 1. Examine the companies balance sheets and statements of cash flow. What is the demand for credit at each company? Did the company obtain new debt or repay old debt? Look at the investing section to determine what the companies did with any additional debt they raised. This will provide a big picture of the financing activities for the year. 2. Consider the source of debt-who supplies the credit? Read the debt footnote and the lease footnote if the company uses leases). Does it use short or long-term debt? Is the debt from banks or is it publicly traded? Does the debt carry covenants that provide protection to creditors? Pay special attention to any mention of default or renegotiated covenants as this can indicate a decrease in creditworthiness. 3. Extend the analysis by computing the following ratios for the current and prior years for the companyies). (Assume a marginal tax rate of 37%.) . Return on equity (ROE) Return on assets (ROA) Return on net operating assets (RNOA) Times interest eamed Operating cash flow to debt Free cash flow to debt Current ratio Quick ratio Liabilities-to-equity ratio Total debt-to-equity ratio Module 4 Credit Risk Analysis and Interpretation 4-52 4. Compare the ratios over time for the company. Is the company more or less liquid or solvent than last year? Compare companies to determine which company is more liquid and solvent . Find two or more credit ratings for the company and use the descriptions in Appendix 4A to interpret the ratings. Read any analysts' credit reports available and compare them to our analysis Compute and interpret the Altman Z-score for the companies and use Exhibit 4.8 to interpret the scores. Is the company at risk for bankruptcy? Does this assessment make sense in the context of other analyses in cluding analysis from prior modules)? . Conclude with an assessment about the company's liquidity and solvency. We should express an opinion about whether the company has an appropriate level and types of debt and whether we expect the company to continue operating with its existing capital structure